Money Supply On Real Gpd

  1. Money Supply And Gdp
  2. Money Supply Velocity And Real Gdp
  3. How To Calculate Real Gdp

Applying the equation of exchange to this economy, we have a money supply M of $500 and a velocity V of 1. Because the only good or service produced is car washing, we can measure real GDP as the number of car washes. Thus Y equals 50 car washes. The price level P is the price of a car wash: $10. If money supply is increasing and velocity is decreasing, the impact on the prices and real GDP is uncertain. The effective money supply should be eq view the full answer.

WRITTEN BY PAUL BOYCE Updated 20 November 2020

Real GDP Definition

Real GDP is Gross Domestic Product (GDP) that accounts for inflation or deflation. In other words, it disregards the impact that higher prices have played in economic growth and allows us to compare the quantity of goods produced rather than the value.

Key Points
  1. Real GDP is Gross Domestic Product (GDP) that accounts for inflation or deflation.
  2. Real GDP allows us to better compare economic growth year on year as it accounts for fluctuations in the supply of money – allowing us to compare the quantity and value of goods produced each year.
  3. We can calculate real GDP by dividing nominal GDP over a GDP deflator.

If we take an example, a Burger costs $10 in Year 1. In Year 2, it may have risen to $11 – indicating an inflation rate of 10 percent. This extra $1 is included in GDP, but does not mean that more goods or services have been created. In both Year 1 and Year 2 – one burger has been manufactured, which it accounts for.

Real GDP considers inflation and removes it from the economic output calculation, whichgives an accurate representation of economic growth year on year. So in this case, the increase in $1 for the burger is not considered – meaning real economic output would remain at $10 as far as the burger is concerned. This allows us to be able to better identify year on year increases in quantity as we can disregard increases in price.

Why Real GDP is used

As GDP calculates the amount of goods and service produced in a country, it is important tosee how this grows over time. Everything in the economy could increase in price by 10percent. This would show a 10 percent growth in economic output, but this does notrepresent the physical goods produced.

We measure GDP using numbers and currency, usually because the information is more easily digested. For instance, it is easier for us to say US GDP is worth $20 trillion; rather than 1 million Fords, 2 billion loaves of bread, 500 million eggs, so on and so forth. However, whilst this is easier for us to determine the value of economic output – it does not help us determine the quantity. By removing inflation, we are able to get a better understanding of how much quantity has increased, but on a value basis.

We use Real GDP in order to get an accurate measure of the economy. This is because nominal GDP measures the value of the economic output, but this doesn’t create a full and accurate picture of how the economy is performing. For instance, Venezuela experienced rapid levels of inflation through the early 21st century – sometimes it reached over 1,000 percent. In such a scenario, it is obvious that the economy is not truly growing at 1,000 percent a year.

To conclude, real GDP adjusts the nation’s economic output so that it considers the GDP in terms of volume growth as opposed to value growth. This allows policymakers to understand true economic performance without inflation distorting the results. By identifying the real rate of economic growth, policymakers may deem it necessary to alter monetary policy – where the money supply is increased or decreased to stimulate growth or reduce inflation. Alternatively, governments may use fiscal policy to reduce taxes and stimulate the economy.

How to Calculate Real GDP

Real GDP Formula

To calculate Real GDP, we divide Nominal GDP by the GDP Deflator. Nominal GDP is just a fancy way of saying GDP. It is just the gross calculation without any consideration for factors such as inflation. So we use this and divide by the GDP deflator. This is essentially the rate of inflation. So for example, if inflation was 5 percent in one year, the GDP Deflator would be 1.05.

Source: Icons made by Anu Rocks, Raj Dev, Free Preloaders, at

Let us now take an example. The US has a nominal GDP of $20 trillion. If the inflation from the previous year was 5 percent, that would make the GDP deflator 1.05. So in this example, we have Real GDP = $20 billion / 1.05. That would mean that Real GDP would equal $19.05 billion.

Real GDP vs Nominal GDP

Nominal GDP is calculated using current prices. This means that it calculates both prices AND growth. For example, a bag of chips may have cost 5 cents in 1969. In 2019, a bag ofchips can cost $5. These are both ‘current prices‘.

So Nominal GDP works out the economic output using current prices. That means whatever $1 was worth in that specific year. So when we say Nominal GDP, really mean prices ANDgrowth. However, nominal GDP makes no distinction between the two. Because it factors inboth, we cannot see how much an economy has actually grown. How many more goods andproducts have been produced year on year? This is what Real GDP allows us to do.

Whilst nominal GDP measures prices AND growth, Real GDP simply measures growth. This is because it excludes price fluctuations that happen due to inflation or deflation.

Source: U.S. Bureau of Economic Analysis, Real Gross Domestic Product [GDPC1], retrieved from FRED, Federal Reserve Bank of St. Louis;


General FAQs on Real GDP

What is meant by real GDP?

Real Gross Domestic Product (GDP) refers to the total change in goods and services produced, accounting for inflation. For instance, the economic output of a nation may increase by 3 percent. This would suggest a relative good rate of economic growth. However, if inflation is also at 3 percent, the economy has not actually grown. When we use the term ‘Real’, we refer to the actual growth in economic output – as inflation cannot be considered as economic growth.

How do you find real GDP?

Real GDP is calculated by dividing nominal GDP by the GDP deflator as shown below.

What is nominal and real GDP?

Nominal GDP measures economic output using current prices. By contrast, real GDP measures output using constant prices.

A primary benefit of measuring the Gross Domestic Product (GDP) is that it can show the growth of the economy over time, or its lack thereof. However, GDP as measured by current prices does not measure the growth of real GDP, since prices depend on the money supply, which varies independently of GDP from year to year. Nominal GDP is the GDP measured by actual prices, which are unadjusted for inflation. Real GDP measures output in constant dollars, so that the economic output of one year can be accurately compared to another year. Since prices change from year to year, GDP would change from year to year even if the real GDP did not change. Hence, there must be some adjustment in GDP to reflect the change in prices. Rising prices inflate GDP while falling prices deflate GDP. Therefore, to obtain real GDP, the operation must be reversed. Since prices usually rise, GDP is deflated by the amount of the inflation to arrive at real GDP. Hence, it is often called the GDP deflator.

GDP Deflator = 100 × Nominal GDP / Real GDP

Real GDP is simply the nominal GDP deflated by the price index:

Real GDP = Nominal GDP / (GDP Deflator/100)

The GDP deflator is based on a GDP price index and is calculated much like the Consumer Price Index (CPI), based on data collected by the government. The GDP index covers many more goods and services than the CPI, including goods and services bought by businesses. The CPI only covers consumer goods and services, while the GDP index also covers capital goods, government purchases, and goods and services traded worldwide.

The Bureau of Economic Analysis (BEA), along with the Bureau of Labor Statistics (BLS), compiles the GDP accounts. BEA is an agency of the United States Department of Commerce that produces and distributes economic statistics about governments, businesses, households, and individuals. The most important of these statistics is the National Economic Accounts, which provides statistics on the production, distribution, and the use of economic output, of which the GDP is the most prominent. Most of the information for calculating the GDP accounts for consumption and investment comes from the United States Census Bureau. Information about government purchases and government wages and benefits, which is the single largest expenditure by the federal, state, and local governments, comes from the United States Office of Personnel Management. The Census Bureau also provides some of this information. Most of the information on net exports comes from the United States Customs Service. The Bureau of Labor Statistics provides most of the statistics concerning labor, which is the major input to GDP.

To determine the value of the GDP deflator, a GDP price index must be constructed that shows how much prices have changed from year to year for a representative sample of all products and services. The relative weights of various goods and services in the GDP price index are adjusted annually, unlike the CPI, which is a fixed weight price index for a market basket whose composition is only updated occasionally by the BLS.

A price index measures how much prices have changed in any given year compared to a base year:

Price of Representative Market Basket in Specific Year
Price Index in a Given Year =×100
Price of Representative Market Basket in Base Year

The multiplication by 100 gives a nice round number, especially for reporting. However, to determine real GDP, the nominal GDP is divided by the price index divided by 100.

To simplify comparisons, the value of the price index is set at 100 for the base year. Previous to the base year, prices were generally lower, so those GDP values must be inflated to compare them to the base year. When prices are less in any given year than they were in the base year, then the price index will be less than 100, so that when real GDP is calculated by dividing the nominal GDP by the price index, it will exceed the nominal GDP. Real GDP = nominal GDP for the base year.

Another method of calculating real GDP is to enumerate the volume of output, then multiplying that volume by the prices of the base year. So if a gallon of gas cost $2 in the year 2000, and the United States produced 10,000,000,000 gallons, then these values can be compared to a later year. For instance, if the United States produced 15,000,000,000 gallons of gasoline in the year 2010, then the real increase in GDP with respect to gasoline could be calculated by simply multiplying the 15 billion by the 2000 price of $2 per gallon. The price index can then be calculated by dividing the nominal GDP by the real GDP. So if gasoline was $3 per gallon in 2010, then the price index = 3 / 2 × 100 =150.

Money Supply And Gdp

Of course, there are many complexities to calculating real GDP by either method. Statisticians must necessarily use assumptions about the proportion of each type of goods and services purchased during a given year. If you would like to dive into the details of calculating this chain-type annual-weights price index, be my guest: Box: Basic Formulas for Calculating Chain-Type Quantity and Price Indexes.

Potential GDP and the Output Gap

Money Supply Velocity And Real Gdp

One factor the Federal Reserve considers when deciding on monetary policy is whether the economy is producing its potential output. Potential output, estimated periodically by the Congressional Budget Office (CBO), is an estimate of what an economy could feasibly produce when fully employing its available economic resources. Hence, potential output is the same as potential GDP and is often described as the maximum sustainable output. Sustainable output means that the economy is functioning normally rather than maximally. So, for instance, employees are working regular hours, not overtime, and factories and other sources of production are producing quantities for which they were optimized. Hence, positive output gaps are possible, where the actual output exceeds potential output, since the economy can utilize its resources at higher levels for short periods of time. However, negative output gaps are far more common. A negative output gap indicates that the economy is under utilizing its resources, which often means that the economy is operating at less than full employment. Negative output gaps occur during recessions and positive output gaps occur during economic booms; thus, the output gap mirrors the business cycle of booms and busts.

Actual Output − Potential Output
Output Gap=×100
Potential Output

How To Calculate Real Gdp

If the output gap is negative, then the Federal Reserve will adjust its monetary policy to stimulate the economy more; if positive, then the Federal Reserve would probably increase the federal funds rate to cool the economy.